Oscar has been passionate about investing since he was 9. He loves talking business, stocks and investment ideas with everyone. He sees the investment process as a life-long learning opportunity in a game setting. Please visit my personal blog (http://sahlbergonstocks.blogspot.com/) for more... More

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It is undoubtedly a tough world out there. The markets are choppy and depressing. And it is tought to invest in such markets. The long-term picture and trend continues to look bleak (see my previous article). But we must always be cognizant about what is going on in the fundamentals of the economy as momentum tends to overshoot the equilibrium points. Of course there is no silver bullet, or a definite answer to whether we have reached the turning point or a tactical rebound (and picking bottoms is best left to monkeys). However, there are certain signs, albeit relatively weak, emanating from the economy that may provide some hints.

First thing to watch is what brought is here in the first place. Key home resale price index have finally stabilized on a month-over-month basis over the past three months. An increased level of rental activity is helping this trend, and while it has not resulted in a boom in home ownership, it is providing a price floor. Rental costs have increased relative to mortgage repayment rates and is at an all-time high since 1994. Unsold new home inventories are at an all-time low since the 1960s and inventories as a month of sales are close to historic lows (excepting the boom and bust between mid-1990s to the 2008 crisis).

Second is that the sentiment in the market is already very strained. The volatility levels have been elevated and sustained for a while and the market risks are being openly discussed by the market. And while this does not mean everything is priced in or perfectly foreseen, the market is at least aware of the potential outcomes (known unknowns as opposed to unknown unknowns, whatever that’s supposed to mean). Domestic fund flows have also seen withdrawal rates resembling the 2008 crisis.

Third point to watch is earnings. Analysts are beginning to revise downwards and we are seeing some EPS disappointments. However, the analyst community is notorious for usually being late in the earnings game. With most of the highly cyclical stocks already down sharply in anticipation of these downward revisions, there is a potential that the impact of the downgrades may not reflect the road ahead correctly. Working backwards, the market is trading at around 10x earnings and this implies that if earnings stay flat from these rates forever, the market is 20% undervalued. Or looking at it from a different angle, taking a 25% earnings decline, the market will be trading at a slight discount to long term average of 15x earnings.

Equity earnings need to be taken in parallel to yields of other instruments as well. After all, there is always a price for things. And if we look at it from the perspective of earnings yield, then the picture gets another dimension. The yield gap between the 10 year and the equities are at historic highs, challenging the levels seen in mid1970s and during 2008. In fact it sits around 6 standard deviations from the norm. So even with the earnings revisions downwards the gap points out to a relative valuation gap between these two asset classes.

With other nascent signs such as gains in business spending and the slow paced recovery in auto sales, investors/tradersmust stay awake and be aware of potential tactical opportunities. After all, there is a right price for everything and positions are not things that one marries blindly to.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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